It is rare that a decision to plough billions of dollars of public money into weak banks is accompanied by an international ratings agency upgrade, but that is what happened in India recently.

On October 24, the government announced Rp2.11 trillion ($34.2 billion) of bank recapitalization measures for public-sector banks over the next two years. And on November 17, Moody’s upgraded the country from Baa3 to Baa2 – a notch above investment grade – for the first time in 14 years.

Moody’s did so because it appears to believe in prime minister Narendra Modi’s reform agenda, of which the recapitalization drive is a part.

Moody’s said the upgrade rests upon an expectation “that continued progress on economic and institutional reforms will, over time, enhance India’s high growth potential and its large and stable financing base for government debt, and will likely contribute to a gradual decline in the general government debt burden over the medium term”.

Viral Acharya, Reserve Bank of India

The public sector recapitalization is only a part of that broader agenda – other elements include the introduction of a goods and services tax, improvements to monetary policy, the use of the Aadhaar national card to boost financial inclusion and the controversial demonetization programme of last November – but it has been widely applauded by the market.

It will work like this. Some Rp181 billion will come from budgetary provisions, Rp1.35 trillion from recap bonds and Rp580 billion from capital the banks themselves are expected to raise.

The details of the recap bonds have not yet been announced, but they are expected to be similar to a programme launched in the 1990s: the government issues bonds, which are purchased by the banks; and the capital raised by those bonds will be infused into the banks as equity capital.

“From the bank’s perspective, it will convert bank liquidity in the form of cash into equity capital, which will enable the banks to meet regulatory requirements, raise leverage ratios and raise capital from the market at better valuations to support credit growth,” says Nomura economist Sonal Varma.

The interest burden on those bonds then falls on the government and will end up in the fiscal deficit, but clearly that burden is not sufficient to have alarmed Moody’s.

Struggles

Something clearly needed to be done about India’s public-sector banks. Most were already struggling with bad debts; capital requirements under Basel III made the situation bleaker still. Analyst estimates of the amount of capital they would require to clean up their balance sheets and meet these regulatory minimums vary from $35 billion to $65 billion.

Consequently, these banks were not lending, since the state of their balance sheets did not allow them to do so and stay anywhere near regulatory minimums.

Even as the Reserve Bank of India has reduced policy rates, “the banking sector’s credit growth has remained much muted,” said Reserve Bank deputy governor Viral Acharya on November 16. “A primary cause of the slowdown has been the weak balance sheets of public-sector banks in view of large non-performing assets, which seem to have made banks risk averse and induced them to reduce the supply of credit.

“Under-capitalized banks have capital only to survive, not to grow.”

Injecting capital is only half of the problem, however. Banks are also going to need to resolve bad loans, one way or another.

Nomura says total stressed assets of public-sector banks stood at 20.1% of total assets in the second quarter of 2017, with 14% classified as non-performing and the remainder as restructured or stressed assets.

At three – Dena Bank, IDBI and IOB – the stressed figure is over 30%. In most cases, provisions against bad loans are insufficient.

In this respect, the Insolvency and Bankruptcy Code, which came into effect in December 2016, as well as an amendment to the Banking Regulation Ordinance and some pressure from the Reserve Bank itself, should make banks refer their largest non-performing assets to resolution.

Some will need to be written off, others restructured and some might eventually come good. But only if the overall bad-debt levels come down can the banks start doing what they should be doing.

“Banks like ours will still make lending mistakes. That’s part of business,” says an executive at one state-backed lender. “But now we should be able to get on with growing.”

The idea is that all of this becomes a virtuous circle.

At State Bank of India, for example, the share price rose over 20% on the news even as it missed earnings targets by 40% (showing just how much more important balance-sheet strength is than growth outlook to investors at the moment).

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